30 ELR 10837 | Environmental Law Reporter | copyright © 2000 | All rights reserved

International Emissions Trading Rules as a Compliance Tool: What Is Necessary, Effective, and Workable?

Robert Nordhaus is a member of the Washington, D.C., law firm of Van Ness Feldman, P.C.; J.D., Yale Law School (1963); B.A., Stanford University (1960). Kyle W. Danish is an associate at Van Ness Feldman; J.D., Temple University School of Law (1997); M.P.A., Princeton University Woodrow Wilson School of Public and International Affairs (1996); B.A., Haverford College (1989). Richard H. Rosenzweig is a principal at Van Ness Feldman; M.A., American University (1984); B.A., Northeastern University (1982). Britt Speyer Fleming is an associate at Van Ness Feldman; J.D., American University Washington College of Law (1997); B.A., Dartmouth College (1994). The authors extend their gratitude to the following individuals for their helpful comments: Christian Albrecht, Carlton Bartels, Timothy Denne, A. Denny Ellerman, Joseph Goffman, Erik Haites, Dale Heydlauff, Fanny Missfeldt, Jake Werksman, Jonathan Wiener, and Thomas Wilson. Responsibility for any errors or omissions rests solely with the authors. EPRI provided financial support for work on this Article. The Article, however, does not necessarily reflect the views of EPRI or its funders.

[30 ELR 10837]

Governments are currently negotiating rules to govern international greenhouse gas (GHG) emissions trading under the Kyoto Protocol to the United Nations Framework Convention on Climate Change (UNFCCC).¹ Emissions trading is a critical element of climate policy because it can allow countries to implement emissions limitation commitments at a significantly lower cost than if such commitments had to be implemented solely from mitigation activities within each country's own borders. Emissions trading thus can promote compliance with the Protocol's emission limitation and reduction commitments; it helps prevent "overemitting."

However, in connection with negotiations on the Protocol, a number of governments and nongovernmental organizations (NGOs) have raised concerns that the inclusion of a trading program provides additional opportunity and incentives for noncompliance in the form of "overselling." "Overselling" will occur if a country that is a party to the Protocol sells allowances that the country ultimately will need to cover its emissions and thus will be unable to meet its emission limitation or reduction commitment.

Governments and NGOs have proposed a number of rules aimed at addressing overselling risks. On one side of the spectrum is an approach that would rely on an already contemplated compliance framework that would not impose up-front restrictions on emissions trading but would punish noncompliance with sanctions. On the other side of the spectrum is an approach that would not allow trading until after the deadline for meeting the emission limitation and reduction commitments and then would limit trades to allowances not needed to meet those commitments. Other proposals would address overselling risks by eliminating the ability of buyers to utilize those allowances for compliance purposes if the seller oversold. The proposals under discussion vary widely in their ability to prevent overselling and in their potential impact on an international emissions trading market.

This Article evaluates the problem of overselling and the rules proposed to address it. It provides an introduction to the Kyoto Protocol and the key provisions in the Protocol related to emissions trading and compliance. It then defines the potential overselling problem and evaluates the extent to which the compliance framework already contemplated under the Protocol could address such risks. The Article outlines the liability rules that have been proposed to supplement the Protocol's compliance framework. Thereafter, the Article outlines a set of criteria for evaluating liability rules and applies these criteria to assess the current options.

The Kyoto Protocol

The Kyoto Protocol was adopted in December 1997 by the Parties to the United Nations Framework Convention on Climate Change.² To date, it has not entered into force under international law.³ The Protocol would impose binding GHG emission limitation or reduction commitments on 39 countries listed in Annex B of the Protocol (Annex B Parties). The commitments apply to six types of GHGs. The Annex B Parties consist, for the most part, of the world's industrialized nations. Countries not listed in Annex B are not subject to emission reduction commitments under the Protocol.⁴

The quantified emissions limitation and reduction commitment for each Annex B Party is set forth in the form of a budget of allowable GHG emissions during a 2008-2012 "commitment period." The Protocol contemplates subsequent contiguous commitment periods. However, the emission budgets for subsequent periods have yet to be negotiated. The emission budgets for the 2008-2012 commitment period, which are called "assigned amounts," are differentiated by country and are expressed by reference to a base [30 ELR 10838] year. For most countries and for most of the types of GHGs, the base year is 1990; in some cases, the base year is 1995. Because Article 3 of the Protocol establishes that each Annex B Party is obligated to conform its 2008-2012 emissions to its assigned amount, many commenters refer to the commitments as the "Article 3 commitments."

The Kyoto Protocol is a work in progress. Government delegations are currently negotiating a variety of rules for its implementation. They are focusing, in particular, on developing rules for the Article 6, 12, and 17 "mechanisms" and rules and institutions for the facilitation and enforcement of compliance with the Protocol. The delegations have set a goal of making final decisions regarding these rules and institutions by no later than the sixth Conference of the Parties to the UNFCCC (COP-6), which will be held in November 2000. The paragraphs that follow describe the key mechanisms and also the currently contemplated framework for enforcing compliance with the Protocol.

The Article 6, 12, and 17 Mechanisms

The Kyoto Protocol authorizes the establishment of a number of "mechanisms" which are intended to provide means for Parties that have Article 3 commitments to meet those commitments through cost-effective cooperative arrangements with other Parties. In some cases, the Protocol provides that not only governments but also "legal entities" (private companies) may use the mechanisms. This Article focuses primarily on the Article 17 emissions trading mechanism and its potential interactions with the Article 6 Joint Implementation mechanism and the Article 12 Clean Development Mechanism.

International Emissions Trading

Article 17 provides that Annex B Parties "may participate in emissions trading for the purpose of filling their commitments under Article 3." Parties participating in Article 17 emission trading would trade parts of their assigned amounts, often referred to as assigned amount units (AAUs).⁵ Article 3 of the Protocol provides that when one Annex B Party transfers AAUs to another Annex B Party through an Article 17 transaction, the AAUs are subtracted from the assigned amount of the former and added to the assigned amount of the latter. Article 17 further provides that the Parties to the UNFCCC "shall define the relevant principles, modalities, rules, and guidelines, in particular for verification, reporting and accountability for emissions trading."

Article 17 of the Protocol does not explicitly authorize or exclude the participation of "legal entities" or "private entities" in emissions trading. By contrast, Article 6 and Article 12 explicitly provide for the participation of such entities in Joint Implementation and Clean Development Mechanism projects. Governments are divided on the question of legal entity participation in emissions trading. Among those governments favoring legal entity participation, there is further division on the mechanics of such participation. For the purposes of the analysis below, this Article assumes that legal entities are authorized to participate in trading but does not analyze all of the various options for the international or domestic rules that would govern their participation.

Joint Implementation

Article 6 provides that the Parties listed in Annex I of the UNFCCC and their authorized "legal entities" may obtain emission reduction units (ERUs) for emission reductions or removals generated by a climate change mitigation project in another Annex I country and then use those ERUs to meet their commitments.⁶ The emission reductions or removals must be additional to those that would otherwise occur without the project.⁷ As with emissions trading, Article 3 provides that, in an Article 6 Joint Implementation project, ERUs are subtracted from the assigned amount of the Annex I Party that hosts the project and added to the assigned amount of the investing Annex I Party.⁸ Article 6 provides that a Party not in compliance with its Article 5 and 7 commitments may not acquire ERUs.

Clean Development Mechanism

Article 12 establishes the Clean Development Mechanism (CDM) under which an Annex I Party, or private entity, may obtain certified emission reductions (CERs) for emission reductions achieved by a climate change mitigation project in a non-Annex I country. Article 3.12 provides that CERs may be added to the assigned amount of an Annex I Party.⁹ As under Article 6, Article 12 imposes an additionality requirement on CDM projects.¹⁰ CDM projects also must contribute to sustainable development in the host non-Annex I country.¹¹

Unlike Article 6, Article 12 explicitly requires third-party certification of emission reductions generated by project activities. This certification responsibility falls to "operational entities" acting under the supervision of a CDM "executive board."¹² Many governments and NGOs have recommended that certification occur on an ex-post basis, i.e., certification is granted only when emission reductions have already occurred as a result of a project.¹³ In [30 ELR 10839] that case, CERs could be said to correspond to certified actual emission reductions.

Many governments and NGOs propose that those Parties that obtain ERUs and CERs should have the ability to resell those ERUs and CERs through the Article 17 emissions trading program. The Group of 77/China negotiating bloc has registered its opposition to any such "fungibility" of AAUs, ERUs, and CERs.¹⁴

The Five-Year Commitment Period

While not technically a "mechanism," the multiyear commitment period established under Article 3 also provides a means for Parties to comply with their Article 3 commitments more cost effectively. The multiyear formulation gives Parties the flexibility to manage their emissions over time, allowing them to take into account annual fluctuations in GHG emissions that could result from business cycles, the weather, and other influences.¹⁵

Benefits Associated With the Mechanisms

A number of economic analyses have concluded that the mechanisms will make the overall costs of implementing the Protocol's Article 3 commitments substantially less than these costs would be if Annex B Parties were required to meet their commitments entirely through activities within their own borders.¹⁶ These analyses reason that some Parties will be able to over-comply with their Article 3 commitments and thereby generatesurplus AAUs.¹⁷ If other Parties with high domestic marginal abatement costs can acquire the surplus AAUs, then those Parties will be able to meet their commitments at a lower cost. Without the mechanisms, Parties that could overcomply would not have the same financial incentives to do so, and Parties with high domestic marginal abatement costs would end up expending additional resources to meet their commitments.

The economic analyses incorporate several assumptions relevant to an analysis of overselling rules. First, the analyses assume the maximum feasible participation by legal entities as both sellers and buyers of AAUs. Second, they assume no restrictions on sales of so-called hot air AAUs. Third, they assume that participants in trading know at the outset of the commitment period precisely what each Party's cumulative 2008-2012 emissions will be and each Party's resulting surplus, if any, of AAUs. Fourth, the analyses assume that each Annex B country that has a surplus will sell no more or less than this surplus, regardless of the financial rewards from AAU sales or from withholding AAUs from the market.

Accordingly, the economic analyses presume full compliance by Parties. Because the analyses presume full compliance, they do not account for the effects of rules that may limit or bar trading in order to enforce compliance or to achieve other purposes.

The Kyoto Protocol Compliance Framework

Based on the text of the Protocol and the thrust of most proposals by governments, it is possible to outline the elements of what this Article will refer to as the "contemplated Kyoto compliance framework." Absent any additional rules to address overselling, the Parties likely would rely on some version of this framework to prevent or deter both overemitting and overselling. The framework consists of (1) self-monitoring and annual reporting by each Party; (2) a system of implementation review and facilitation; and (3) some form of end-of-period sanction for any Party that fails to meet its Article 3 commitment.

Self-Monitoring and Reporting

Articles 5 and 7 of the Protocol require Parties to monitor and report on their annual emissions of GHGs and otherwise provide information needed to assess their compliance status.

Article 5 provides that each Annex I Party must have in place by no later than 2007 "a national system for the estimation of anthropogenic emissions by sources and removals by sinks of all [GHGs regulated under the Protocol]."¹⁸ Article 5.2 further provides that where a Party fails to use approved methodologies for estimating its emissions, "appropriate adjustments shall be applied according to methodologies agreed upon by the Conference of the Parties serving as the meeting of the Parties to this Protocol [(COP/moP)]."¹⁹

Under Article 7 of the Protocol, each Party is required to submit an annual inventory of its emissions along with the "necessary supplementary information for the purposes of ensuring compliance with Article 3, to be determined in accordance with [7.4]."²⁰ Article 7.4 empowers the COP/moP to "adopt . . . guidelines for the preparation of the information required under [Article 7]."²¹

A number of governments and NGOs have proposed that each Annex I Party be required to establish a national registry for tracking its holdings of AAUs, ERUs, and CERs.²² In addition, various entities have proposed the establishment of a system that would identify each AAU, ERU, and CER [30 ELR 10840] held by the Party of origin (and even by project in the case of ERUs and CERs) and track and report transactions involving these emission units on a real-time basis.²³ The proposals have suggested a variety of approaches for the establishment of international and domestic registries, the interaction of these registries, and the identification of AAUs.²⁴

Implementation Review and Facilitation

Another provision in the Protocol, Article 8, would establish "expert review teams" to review and report on information submitted by Annex I Parties under Article 7. The teams are to "provide a thorough and comprehensive technical assessment of all aspects of the implementation of [the] Protocol." Governments and NGOs have submitted a variety of proposals with respect to which individuals should serve on teams, how they should be selected, and the extent of their powers.²⁵

Broad agreement exists among governments and NGOs on the need for a compliance institution empowered to act upon reports by the Article 8 teams and by other Parties.²⁶ This institution would facilitate implementation of commitments under the Protocol through advice, aid, and warnings.²⁷

One of the most important potential constraints on this system of implementation review and facilitation is the time involved in submitting, reviewing, and acting upon annual emission inventories. In a March 2000 UNFCCC technical workshop, a representative from the Secretariat suggested that the process of submission and expert review of inventories might take as long as 38 months.²⁸ On the other hand, some advanced industrialized countries may already be capable of submitting their inventories in under a year.²⁹

End-of-Period Sanctions

Most governments and NGOs also envision that the compliance framework will be empowered to administer an end-of-period sanction against a Party that fails to meet its Article 3 commitment. The Protocol does not specify sanctions. The sanctions that have been under discussion fall into three general categories: repayment sanctions, suspension sanctions, and financial sanctions.

A potential legal hurdle to effectuating sanctions is that Article 18 of the Protocol provides that establishing "binding consequences" for noncompliance requires an amendment to the Protocol.³⁰ Another potential hurdle is Article 27, which provides that a Party may withdraw from the Protocol at any time after a year's notice.³¹ The text in these provisions, and the consent-based nature of international law generally, may mean that it will be difficult to guarantee that all Parties are subject to sanctions at the end of the first commitment period if they overemit or oversell. These issues are explored in greater detail below. The following paragraphs describe the different types of sanctions currently under discussion.

] [ Repayment Sanctions. The aim of a repayment sanction is to ensure that a Party with an overage at the end of one period remains accountable for that overage in the subsequent period, i.e., to "balance the books" with regard to a Party's liability for noncompliance. A repayment sanction can achieve this objective by deducting the overage from the Party's assigned amount for the subsequent commitment period.

Some commenters have expressed concern that merely balancing the books with a repayment sanction may not be enough because it makes possible a cycle in which a Party continuously undercomplies and carries over its default to the next period.³² For this reason, some have proposed that a repayment sanction also incorporate an interest component of sufficient size to encourage Parties to comply in the first commitment period rather than carry over their liability into the second. The United States has indicated its support for this approach.³³

In addition to the general difficulties with sanctions described above, a potential obstacle to operationalizing an effective repayment sanction for the Protocol's first commitment period is the delay in negotiating assigned amounts for the second commitment period. If the Parties are negotiating the assigned amounts for the second period shortly before or during the first commitment period, a Party that is aware of the likelihood of an overage would have an opportunity to negotiate a more generous second period assigned amount for itself. A repayment sanction would have little deterrent effect if it was possible for Parties to negotiate around it. On the other hand, such a negotiating strategy might have a low probability of success; each Party presumably will press for a generous assigned amount for itself and resist other Parties' efforts to do the same.

] [ Suspension Sanctions. With a suspension sanction regime, a Party that overemitted or oversold in the first commitment period would face strict restrictions on its use of the Kyoto mechanisms in the second period or would be prohibited from participating in the mechanisms altogether. Such a sanction aims not only to deter first commitment period noncompliance but also to prevent second commitment period noncompliance by a Party that has demonstrated itself to be at risk of overselling.

[30 ELR 10841]

[ [ Financial Sanctions. Financial sanctions, or monetary penalties, aim to deter violations by eliminating the economic benefits a Party could derive from its noncompliance. The European Union has asserted its support for a financial sanction.³⁴ Issues have been raised during negotiations regarding the effectiveness of financial sanctions in deterring overselling and the political challenges associated with implementing such a sanction. For example, if a Party's cost of domestic abatement exceeded the sanction, the Party might simply decide to pay the sanction rather than comply. Thus, financial sanctions do not provide complete assurances that the Protocol's specific emissions limitations ultimately are met by Parties.³⁵ In addition, a persistent question in the negotiations is whether financial penalties large enough to accomplish the dual aims of deterrence and restitution are politically viable.

Assessing the Need for Additional Rules to Address the Risk of "Overselling"

What Factors Contribute to the Risk of Overselling?

As discussed above, international emissions trading can reduce the costs of meeting the Protocol's Article 3 commitments. By reducing costs of implementation, the trading mechanism will promote compliance. However, the ability to engage in emissions trading combined with the five-year commitment period also introduces a risk of noncompliance in the form of "overselling." In the context of the Kyoto Protocol, overselling could occur if a Party issued AAUs during the commitment period that it ultimately needed to cover its emissions at the end of the commitment period.

Overselling risks are associated with two scenarios: administrative failure and willful noncompliance.

Overselling Due to Administrative Failure

Studies of compliance with international commitments show that countries often accept treaty obligations without a clear plan for implementing those obligations. These studies conclude that noncompliance frequently results from lack of administrative capacity or from good-faith miscalculation of what will be needed to implement treaty requirements.³⁶ Under the Kyoto Protocol, overselling could result if countries lacking in administrative capacity are unable to implement the domestic elements of an international emissions trading program.

Parties choosing to trade AAUs during the commitment period confront a number of administrative complexities. These Parties will be selling their AAUs up to five years before they know precisely what their 2008-2012 emissions will be. To avoid overselling, they will have to forecast the effectiveness of their domestic implementation programs and monitor the international AAU market. Parties that authorize legal entities to issue AAUs will have to monitor and regulate their trading activities. These administrative tasks will require significant expertise and resources. Participation by governments and legal entities in emissions trading thus introduces the risk of a variety of administrative errors.³⁷

In addition to the risks of administrative failure, unintentional overselling could occur if emissions increased late in the commitment period as the result of unpredictable events or events beyond the control of the government, such as extreme weather, war, or natural disaster.

Some Parties might lack the administrative resources to implement the rigorous domestic systems of implementation review and enforcement needed to avoid overselling due to administrative failure or failure to provide for unforeseen circumstances. In this regard, some commenters have emphasized the importance of keeping in mind that the likely sellers of AAUs in the first commitment period will be countries with economies in transition (EITs) and their legal entities. These commenters note that some of the EITs continue to face substantial administrative challenges as they restructure their governments and economies. These continuing administrative challenges have made it difficult for the EITs to implement their commitments under various other international accords.³⁸

Willful Overselling

Emissions trading introduces the risk that some Parties will issue AAUs solely to maximize revenues and without regard to their Article 3 commitments. Such a Party, a "rogue" trader, could obtain all of the financial rewards of its noncompliance while still receiving the benefits of every other Party's mitigation efforts.

Here again, some commenters have emphasized the importance of recognizing that the predominant sellers in the first commitment period likely will be countries with economies in transition. Given the pressing financial needs of some of the EITs, these commenters have expressed concerns that domestic constituencies in those countries might impose significant pressure on their governments to maximize revenues from trading without regard to commitments [30 ELR 10842] that: (1) will not come due for up to five years and (2) are owed to other countries in any event.³⁹

Is it reasonable to establish rules based on the expectation that some Parties will flout, or at least neglect, their legal obligations if it is profitable to do so? Past international practice is a somewhat unclear guide. It can be difficult to determine whether historical incidents of treaty violations reflected good-faith administrative failure, willful defection, or something in between. What is clear, however, is that in the cases of other treaties in which a party could obtain financial or other rewards for noncompliance, noncompliance has been a problem.⁴⁰

Will the Contemplated Kyoto Protocol Compliance Framework Be Adequate to Address Overselling Risks?

If one concludes that these factors contribute to a substantial risk of overselling, the next question is whether or not the contemplated Kyoto Protocol compliance framework can address these factors adequately.

As discussed above, there is somewhat broad agreement among governments that the Kyoto Protocol compliance framework should consist of self-reporting and third-party implementation review backed by the threat of sanctions. If it were effective in addressing overselling risks, this kind of framework would be preferable to other proposals as it would maximize the potential of emissions trading to reduce compliance costs. The framework would impose relatively low administrative and transaction costs on the emissions trading mechanism. Parties essentially could trade freely subject to severe sanctions for overselling. This framework bears a resemblance to the compliance framework for the U.S. SO₂ Emissions Trading Program, which, by almost all accounts, has generated environmental and economic benefits without instances of overselling.

Unfortunately, there are several reasons why such a framework could be difficult to apply effectively in the context of the Kyoto Protocol.

Effectiveness of Self-Reporting and Implementation Review and Facilitation

The self-reporting and implementation review elements of the framework likely would not prevent overselling by a rogue Party. These elements might even be insufficient to prevent cases of overselling due to administrative failure. This problem is caused by the lag time between a Party's AAU sales and the submission and review of the Party's emission inventories.

As discussed above, it may take two years or more for Parties to inventory their annual GHG emissions from numerous sources and sinks—ranging from factories to forests to livestock—and to obtain expert review of these inventories. If information on emissions lags two years behind sales of AAUs for the length of the first commitment period, even Parties intending to comply might accumulate a large deficit of AAUs relative to their emissions before they or the compliance institution, could detect the problem.⁴¹

This "lag-time" issue reflects a point where the resemblance between the Kyoto Protocol framework and the U.S. SO₂ program breaks down. Under the U.S. program, both firms and regulators can obtain "real time" information not only on sales of allowances but also on emissions. Each firm participating in the SO₂ program controls a comparatively few number of sources and each source must use a Continuous Emission Monitoring System (CEMS) capable of measuring its emissions as they occur. U.S. law prohibits owners and operators of sources in the SO₂ program from disrupting the operation of CEMS.⁴² Indeed, persons who knowingly tamper with monitoring equipment such as CEMS face potential imprisonment.⁴³ For the foreseeable future, it will be neither technically feasible nor politically acceptable to require that all sources of GHG emissions in all Annex B countries operate CEMS.⁴⁴ As a result, at least one of the elements that has contributed to the effectiveness of the U.S. program's system of implementation review will not be available to the Kyoto Protocol's system.

Effectiveness of Sanctions

Because the self-reporting and implementation review elements of the contemplated compliance framework likely would not prevent overselling, the framework must rely in great part on the deterrent effect of post-2012 sanctions. If sanctions of any of the three types under consideration could be of sufficient magnitude and credibility, they likely would be effective deterrents. However, in the context of the Kyoto Protocol, there are a number of legal, political, and institutional obstacles to the establishment of sizable and unavoidable sanctions.

] [ Legal Obstacles. First, as noted above, the text of the Kyoto Protocol establishes legal hurdles to the effectuation of a sanctions regime. Article 18 of the Protocol states that at the first meeting of the COP/moP (which, under Article 13.6, occurs after the Protocol enters into force), that body shall adopt procedures and mechanisms to determine and address noncompliance, including "an indicative list of consequences."⁴⁵ However, Article 18 also provides that "any procedures and mechanisms under this Article entailing binding consequences" can be adopted only by amendment to the Protocol.⁴⁶ The Protocol appears to contemplate an amendment process that can begin only after the Protocol [30 ELR 10843] has entered into force, and which requires consensus or three-fourths support of the Parties.⁴⁷ Nonassenting Parties are not bound by the sanctions amendment.⁴⁸ Accordingly, it may be difficult to ensure that all of the Parties participating in trading are subject to sanctions. In addition, even if all Parties assent to sanctions, Article 27 of the Protocol still provides each Party the right to withdraw from the Protocol after a year's notice.⁴⁹

There appears to be at least one relatively straightforward solution to the difficulty of ensuring that at least those Parties participating in trading have acceded to an amendment establishing sanctions. As discussed above, Article 17 provides that the Conference of the Parties shall define the relevant "rules [for] . . . accountability for emissions trading." The Conference of the Parties could use this Article 17 authority to establish, as an accountability rule for trading, that a Party only may issue AAUs if it also has made itself subject to whatever sanctions are established under Article 18.⁵⁰ Such an Article 17 rule would not itself constitute a binding consequence necessitating an amendment of the Protocol because the Article 18 amendment requirement applies only to "any procedures and mechanisms under this Article entailing binding consequences." (Emphasis added.) Such eligibility requirements might also condition the ability to issue AAUs on a Party's pledge to cure any overage before exercising its withdrawal right.

Political and Institutional Obstacles

Even if government negotiators can surmount the legal obstacles to developing and administering post-2012 sanctions, a sanctions-based enforcement strategy faces other political and institutional obstacles. First, to deter willful overselling, the sanction would have to exceed the economic benefits of overselling, which, depending on the market price for AAUs, could be very substantial. In addition, because the sanction would take effect five years after the commencement of trading, the sanction would have to be at a level to take into account the time value of the economic benefits of overselling to the issuing Parties.⁵¹ Here again, the fact that the issuers will consist largely of countries with economies in transition is relevant because countries with such sizable financial needs could discount the future rather substantially. For these reasons, a sanction of sufficient magnitude to deter overselling would have to be very high.

Heavy reliance on a sanction of this size to deter overselling presents at least two problems. The first problem is credibility. Sovereign nations rarely empower international institutions to use sanctions as the principal means of enforcing their treaty obligations.⁵² Indeed, two prominent international legal scholars have gone so far as to assert that "sanctioning authority is rarely granted by treaty, rarely used when granted, and likely to be ineffective when used."⁵³ Accordingly, even if the Parties agree to grant the incipient compliance institution the power to levy sanctions, the threat that this institution will apply massive sanctions in 2012 might not constitute a sufficiently credible deterrent to a Party contemplating willful overselling in 2008-2010. Reliance on a sanction-based enforcement strategy thus could lead to brinksmanship that would leave the climate regime in a difficult political position at the end of the first commitment period.

Perhaps an even greater problem with using sanctions as the primary means of enforcement is that such sanctions would have to apply not only to Parties that oversold willfully but also to those that oversold unintentionally. The latter Parties might conclude that the compliance institution's application of massive sanctions against them is unfair and illegitimate.⁵⁴ As a result, there is a risk that these Parties would refuse to submit to the sanctions or even withdraw from the Protocol.⁵⁵

Here again, the difficulties of relying on a sanction-based enforcement strategy as the primary means of deterring overselling are illustrated by contrasting the Kyoto Protocol context with that of the U.S. SO₂ Emissions Trading Program. As noted above, the U.S. program requires annual compliance, which means that the financial sanction for overselling, while large, can still be of reasonable size. Well-established domestic adjudicatory institutions and agencies administer the sanction. Those institutions administer the sanction against firms, not sovereign nations. The program is a mandatory rather than a consent-based arrangement; firms cannot opt to withdraw. Indeed, all of these factors, none of which is present in the Kyoto Protocol context, make it possible for the SO₂ program to incorporate not only a financial sanction for overselling but also a threat of imprisonment in cases where the overselling is intentional; the CAA provides that "any person who knowingly" violates any requirement of the SO₂ program is subject to a prison term of up to five years.⁵⁶ It is, to say the least, difficult to imagine imposing criminal liability for intentional overselling under the Kyoto Protocol.

[30 ELR 10844]

Avoiding a Cure Worse Than the Disease

Without implementing unavoidable sanctions compelling enough to outweigh the possible benefits from overselling, the Protocol's contemplated compliance framework cannot prevent overselling. This raises the fundamental question: Absent additional safeguards, will overselling occur and, if so, how much? As discussed above, past experience with treaties suggests that where implementing treaty commitments is complicated or where noncompliance can lead to a net financial gain, noncompliance has been a problem. Both factors are present in the context of the Kyoto Protocol's first commitment period. In this Article, we do not otherwise undertake a formal analysis of the probability of overselling, but rather leave it to negotiators to assess how significant the risk of overselling will be without additional measures to address it.

In such an assessment, the negotiators also will need to take into account the implications of such additional measures on the emissions trading market. A trading rule so restrictive that it severely diminishes the ability of emissions trading to reduce compliance costs could cause more non-compliance than it prevents. More fundamentally, proposed trading rules to address risks of noncompliance in the first commitment period must be assessed in light of the long-term priorities of what most observers assume will be a decades-long international effort to address concentrations of GHGs. As discussed above, sovereignty means that a country may not be compelled to participate in a treaty. In the case of the international climate change regime, the temptation to withdraw could be significant because policies to address climate change will be costly to the Parties that undertake them while the benefits will be shared equally by both Parties and non-Parties. Accordingly, there exists a strong "free-riding" incentive.⁵⁷ To deter such free-riding, it will be important to develop policies that assure countries that their costs of implementation will be reasonable and that their efforts will not be undermined by others' gross misfeasance. In addition, it will be important that rules designed to address overselling do not burden the new Kyoto Protocol compliance institution with roles that exceed its resources or its perceived legitimacy.⁵⁸ The aim of trading rules therefore should be to minimize overselling risks in the first commitment period consistent with the promotion of continued participation and cooperation.⁵⁹ Policies aimed at maximizing compliance in the first commitment period should not undermine efforts to establish a regime that gives key countries incentives for continued participation.

Summary

If the contemplated Kyoto Protocol compliance framework and its approach to overemitting could address overselling risks effectively, the framework would be preferable because it would impose minimal costs and restrictions on emissions trading. However, for several reasons, this framework is unlikely to prevent overselling. First, the self-reporting and implementation review elements of the framework likely would be ineffective in preventing willful overselling and might also be inadequate to prevent cases of overselling due to administrative failure. As a result, the framework effectively relies on sanctions as the primary means of addressing overselling.

Yet, a sanctions regime faces a variety of legal hurdles: it might not take effect at all during the first commitment period and even if it does take effect, would not apply either to a Party that fails to accept it or opts to withdraw. Even if it is feasible to surmount these legal obstacles to the effectuation of a sanctions regime, heavy reliance on sanctions is fraught with other political and institutional difficulties.

For these reasons, if policymakers are concerned about overselling risks, they should consider adopting a reasonable safeguard to supplement the contemplated compliance framework. Policymakers should evaluate proposed rules to determine whether they minimize overselling risks, maintain the ability of emissions trading to reduce costs of implementation, and place a administrative burden on the new compliance institution that is commensurate with its resources and standing.

Proposed Liability Rules for Trading

As a means of facilitating negotiations on the Article 6, 12, and 17 mechanisms, the chairmen of the COP's "subsidiary bodies" have drafted a single negotiating text which articulates a range of options for rules to govern the mechanisms (Chairmen's Negotiating Text).⁶⁰ The existing proposals for liability rules for trading can be found in that Negotiating Text.⁶¹

The Chairmen's Negotiating Text contains not only options for liability rules but also options for eligibility requirements for the mechanisms. The eligibility requirements would condition the ability of a Party to participate in the mechanisms on its compliance with various obligations under the Protocol, such as registry and reporting requirements under Articles 5 and 7. While the proposals for eligibility requirements prompt various legal and substantive issues that also merit close consideration, this Article will focus primarily on the liability rules.

[30 ELR 10845]

The Negotiating Text includes seven options for liability rules. Each of the options except for one would allow trading during the commitment period but would aim to prevent or deter overselling. The exception is the "Surplus Units" Option, which would address overselling by banning all trading during the commitment period. This rule, which has been proposed by the G-77/China negotiating bloc, would allow Parties to trade only those AAUs that are surplus to their emissions at the end of the commitment period. This approach would eliminate overselling, albeit by eliminating most of the benefits of using emissions trading as means of promoting compliance or as an incentive for making additional emission reductions. This option is not analyzed in depth in this Article.

The other six options fall into three basic categories. The first category would rely on the contemplated compliance framework to address overselling risks. The second category would shift some or all of the liability for a Party's overselling onto buyers. The third category would maintain liability in the originating Party but impose a quantitative constraint on the amount of its AAUs the Party could transfer.

Each of the options only would apply to transfers of AAUs (and, in some cases, ERUs) from one Party's registry to another Party's registry. The proposals therefore would not regulate a range of commercial AAU transactions, such as forward transactions (involving purchase or sale of a quantity of AAUs at the current market price with delivery and settlement on a specified future date) and options (involving a contractual right to buy or sell AAUs at an agreed price anytime within a specified period).⁶²

A description of the three basic categories and the proposed rules that fall into each of those categories are provided below.

Originating Party Liability

One of the six options, Option 1 (Originating Party Liability), essentially would rely on the Protocol's contemplated compliance framework to address overselling risks.⁶³ Under this proposed rule, an originating Party would be liable for its overselling. Parties that acquired AAUs from a noncompliant Party would face no restrictions on the use of those AAUs for compliance purposes. This approach is sometimes referred to as a "seller liability" or "issuer liability" rule. The rule would use the compliance framework's combination of self-reporting, implementation review, and sanctions to minimize overselling risks. The other proposals for tradingrules aim to improve upon this approach.

Acquiring Party Liability

Three of the six options—Options 2, 3, and 4—would address overselling risks by shifting some or all of the liability for an originating Party's overselling onto those Parties who acquire, or whose legal entities acquire, AAUs from that Party. Under these rules, an originating Party still would be subject to sanctions for noncompliance with its Article 3 commitment but, in addition, some or all of the AAUs it transferred to other Parties could not be used by those Parties to meet their Article 3 commitments.

The theory behind the Acquiring Party Liability approach is that, facing potential liability for the originating Party's noncompliance, buyers will have strong incentives to structure their acquisitions on the basis of an evaluation of the originating Party's likelihood of compliance.⁶⁴ Facing this scrutiny, originating Parties seeking to profit through emissions trading will have incentives to take steps during the commitment period to manage their emissions and transfers. The emissions trading market would price AAUs sold by each Party or its legal entities on the basis of the market's assessment of that Party's likelihood of compliance. The Acquiring Party Liability approach thus seeks to harness the market forces created by international emissions trading to deter overselling as an alternative to relying solely on international institutions.

A description of each of the Acquiring Party Liability options follows.

Option 2: Shared Liability⁶⁵

Option 2 calls for "Shared Liability." Under this proposed rule, an originating Party would be fully liable for its failure to meet its Article 3 commitment. In addition, a "portion" of the AAUs transferred by the Party to others would be invalidated and could not be used by the acquiring Parties to meet their Article 3 commitments.

The text does not specify the size of the "portion." However, it does make clear that the portion is not limited to the amount of AAUs that were oversold. The text states that the portion to be invalidated "shall be some multiple of the degree of noncompliance."⁶⁶ Accordingly, this rule would more than restore the amount of a Party's noncompliance. Depending on the size of the "portion," application of the rule in particular instances could mean that 100% of a noncompliant Party's sales would be invalidated.

Option 3: Acquiring Party Liability⁶⁷

Under this proposed rule, 100% of the AAUs transferred by a Party that fails to meet its Article 3 commitment would be invalidated in the hands of their buyers.

Option 4: Trigger⁶⁸

The "Trigger" rule represents a hybrid approach. This option implicitly acknowledges the virtues of having at least a partial Originating Party Liability regime. The Trigger rule would apply Acquiring Party Liability only to those Parties that had demonstrated a higher risk of noncompliance.

Under this proposed rule, each Party would begin the commitment period trading subject to an Originating Party Liability rule. The option provides, however, that if a "question is raised" during the commitment period about a Party's [30 ELR 10846] compliance with its Article 3 commitment, any subsequent sales are subject to Acquiring Party Liability.⁶⁹ The text makes clear that further rules would be needed to define the particular circumstances under which a question could be raised about a Party's compliance status.⁷⁰

Originating Party Liability With a Quantitative Constraint

Options 5 and 6 would retain the Originating Party Liability approach but would impose a quantitative constraint on the amount of AAUs a Party could sell. Each option would establish a different formula for the constraint.

Option 5: Compliance Reserve⁷¹

This rule would require that some percentage of every transfer of AAUs be set aside in a reserve and not used or traded during the commitment period. At the end of the commitment period, reserved AAUs would be returned to the Party of origin if that Party complied with its Article 3 commitment. The Party then could transfer the AAUs during a post-2012 "true-up" period or bank the AAUs for use in future commitment periods. If the originating Party failed to comply with its Article 3 commitment, the AAUs would be invalidated, in which case they could not be used or traded. The Negotiating Text leaves the size of the percentage unspecified for now.

Option 6: Units in Surplus to Plan⁷²

The government of Switzerland has proposed this annual post-verification trading system. Under this approach, each Party that wants to transfer AAUs must notify the UNFCCC Secretariat before the commitment period of how it wishes to allocate its assigned amount among the five years of the commitment period. The Party may allocate its assigned amount in any manner it desires, subject to a restriction on the range assigned to any single year (+/- 20% of the annual average is suggested). The Party then can adjust this allocation for any remaining years of the period by notifying the Secretariat in advance of the year(s) in question.

Each year, the UNFCCC Secretariat would issue "certified" excess AAUs to Parties whose cumulative assigned amount allocation from 2008 through the given year was above its cumulative emissions for the same period.⁷³ "Certified" excess AAUs, once issued by the UNFCCC Secretariat, would be tradeable internationally by Parties and legal entities without restrictions.

Framework for Evaluating Proposals

Proponents of emissions trading argue that it promotes compliance with Article 3 commitments by lowering compliance costs, especially where legal entities participate in the market as sellers and buyers. Costs of complying with the Article 3 commitments without international emissions trading would be significantly higher, increasing the risk of noncompliance.

Skeptics argue that emissions trading can contribute to noncompliance by creating an incentive for a Party to oversell. They propose trading rules that are designed to deter or prevent such behavior. However, such rules may also increase administrative and transaction costs associated with participation in international emissions trading, or otherwise contribute to the distortion of the international emissions trading market, thereby reducing economic and environmental benefits. To the extent that a rule inhibits the international emissions trading program, it also increases the risks of noncompliance, e.g., by (1) making it more difficult for Parties whose marginal costs of domestic abatement activities are high relative to those of the rest of the world to buy AAUs, or (2) making it more difficult for Parties to sell AAUs early in the first commitment period and use the proceeds to finance future abatement activities.

Until end-of-period sanctions are in effect and applicable to all Parties, trading rules may be necessary to deter overselling. However, even if policymakers accept the proposition that trading rules are necessary because end-of-period sanctions—at least for the present—are insufficient to deter overselling, any proposed trading rule still should be evaluated to determine both whether it is effective and whether it is workable. A rule that is ineffective burdens international emissions trading without reducing overselling. A rule that is unworkable imposes more burdensome constraints than are necessary to prevent or deter overselling. This section of the Article outlines a recommended framework for evaluating proposed trading rules.

Effectiveness of a Proposed Rule in Preventing or Deterring Overselling

A key consideration in the choice of trading rules is whether a rule will be effective in preventing or deterring overselling. This judgment requires both a review of the details of the trading rule and the type of trading behavior it is designed to bar or deter.

Trading Behavior Targeted by the Rule

The first step in determining whether a trading rule is effective in preventing or deterring overselling is to identify the trading behavior causing the overselling that one reasonably should expect the rule to prevent.

Dealing with the hypothetical willful overselling (or rogue trader) scenario requires careful attention to the design of trading rules, particularly if one assumes the noncompliant Party is a clever rogue. Some of the current proposals are capable of evasion by a Party determined to maximize revenues from AAU sales. For example, as discussed below, the "Trigger" rule might not prevent a Party from selling off most or all of its assigned amount to willing buyers before Acquiring Party Liability is officially activated [30 ELR 10847] for that Party. Similarly, under the Compliance Reserve option, the rule might specifya reserve requirement that is just right for some countries but too small for others. In that case, the rule would not prevent the latter countries from overselling.

The administrative failure scenario describes a Party that endeavors in good faith to comply with its obligations, but does not do so because of failure to project or monitor emissions or to adopt an effective domestic implementation program. Trading rules that require annual monitoring and reporting of emissions when combined with effective end-of-period sanctions, are likely to induce Parties who are otherwise motivated to comply to pay careful attention to the details of their implementation. Thus, these types of trading rules are likely to be more effective against the well-meaning than the rogue trader. More importantly, if one assumes that a Party will be a long-run participant in an international GHG control program, then an end-of-period repayment requirement will not only provide incentives for compliance during the first budget period, but also will ultimately make the environment whole through required GHG reductions in future periods.

Trading rules will not preclude unpredictable or uncontrollable events that result in overselling, but rules can be designed to encourage Parties to accommodate the possibility of these events in calculating their surplus AAUs. Originating Party Liability with sanctions can also make the environment whole through repayment requirements. Acquiring Party Liability requirements, on the other hand, may be less effective for unpredictable and uncontrollable events than for other causes of overselling, since buyer due diligence cannot anticipate such events. Acquiring Party Liability could make the environment whole, however, AAUs in acquiring Party's hands are invalidated to the extent that the originating Party is in noncompliance.

Deterring Gaming

Although most commenters recognize that designing trading rules to prevent or deter overselling will to some extent impede emissions trading and raise the overall cost of compliance with the Protocol, they argue that incurring these costs is justifiable because the trading rules are necessary to prevent or deter such behavior. However, trading rules that both impose higher compliance costs and are inadequate to prevent overselling result in the worst of both worlds. An evaluation of proposed trading rules must carefully assess whether the rules will, in fact, achieve their intended objective. As demonstrated in the analysis of the proposals, some of the current proposals can be evaded by a Party that is determined to do so.

Making the Environment Whole

One of the key objectives of any compliance regime is "making the environment whole" in the event that a Party fails to comply with its emission limitation under the Kyoto Protocol.⁷⁴ While the best outcome would be a regime that ensured universal compliance, any well-designed compliance system must contemplate the possibility (or likelihood) that one or more Parties' GHG emissions (net of transfers) will exceed their Kyoto targets, and that as a result, aggregate Annex I emissions could exceed the Protocol's overall target for a budget period. In that event, emissions reductions in excess of those already required in the subsequent budget period will be necessary to retain the contemplated aggregate level of emissions reductions and "make the environment whole." Most proposed trading rules reflect this objective, by attempting to ensure either that trading will not contribute to noncompliance (as in the G-77/China and Swiss proposals) or, to the extent it contributes to noncompliance, that noncompliance is cured either at the end of the current period through a true-up or through a repayment with interest sanction in the next budget period.

As noted in the general discussion above, end-of-period sanctions, such as a requirement to repay with interest in a later budget period, are ineffective against a Party that withdraws from the Protocol or that refuses to ratify the Protocol amendment imposing sanctions.

Encouraging Ongoing Program Improvement

One key objective of trading rules should be to create a commercial environment in which Parties have strong incentives to continually scrutinize and improve their domestic implementation programs. Most proposals contemplate elements, e.g., monitoring, reporting, and registries, that encourage competent administration of a Party's domestic compliance program, and responsible projections of AAUs likely to be surplus to compliance needs.

Coverage of Joint Implementation and CDM Transactions

This Article largely focuses on market rules for trading AAUs. However, most international emissions trading framework proposals contemplate a regime under which AAUs under Article 3, ERUs under Article 6, and CERs under Article 12 once issued, are fully interchangeable in trades. The trading rules discussed in this Article thus will have important implications for trading in these additional "currencies." There may be a limited need for trading rules that regulate trading in ERUs in order to deter overselling. However, a trading rule need not regulate resale of CERs because of the provision for international third-party review of CDM projects.

Article 6 joint implementation (JI) projects require project-by-project review. Any ERUs obtained by an investing Party (or its legal entities) must be subtracted from the host country's AAUs. However, Article 6 has no explicit requirement that the projects be certified or validated on an individual basis by a qualified independent organization, as under the CDM. Thus, it is possible that the sale of a large number of ERUs from an ill-conceived joint implementation project, producing no emission reductions, might transfer away AAUs necessary to cover other host country emissions and thereby contribute to the host country's noncompliance. Subtracting ERUs from the host country's assigned amount does not cure this problem (it only prevents double counting). On the other hand, if making ERUs freely tradable were conditioned on project-by-project review of JI projects by a qualified independent organization, it would be less [30 ELR 10848] likely that joint implementation could contribute substantially to a host country's noncompliance.⁷⁵ Under this analysis therefore, ERU transactions should be subject to the same trading rules as AAU transactions unless ERU transactions are subject to independent review.⁷⁶

Under the Article 12 CDM, originating Party noncompliance will not increase since the originating Party in a CDM project is a non-Annex I country and therefore not subject to any quantified emissions limitation under the Protocol. It is possible that Annex I countries could contribute to their own noncompliance by reselling CERs necessary for their own compliance. But, in these circumstances, reselling CERs, assuming CERs may be resold, poses no greater a problem than reselling AAUs purchased from other sellers. Thus, there is no apparent reason from an Annex I compliance perspective for treating resales of CERs differently than resales of AAUs. Secondary market rules for CERs and AAUs should be the same. In addition, CDM projects are individually reviewed by an international third party on an ex-post basis, which means they are not subject to the same administrative failure and willful noncompliance risks as AAU transactions.

Conclusions Respecting Effectiveness

Any proposed trading rule should be evaluated to determine the extent to which—in a range of situations, including willful noncompliance, administrative breakdown, and unpredictable and uncontrollable events—the proposal will be effective to deter or prevent overselling. This evaluation should take into account (a) whether the rule can be evaded, (b) whether it encourages ongoing compliance, and (c) whether, in cases of noncompliance, the environment will ultimately be made whole.

Workability and Market Impacts of the Proposed Rule

If trading rules are to be used as a compliance tool, they need not only be necessary and effective, they also must be workable. The workability judgment entails considering the administrative burden of implementing the rule, transaction costs, whether the rule will reduce benefits from trading, whether it will impede trading by legal entities and whether there are less burdensome means to reach the objectives.

Can the Requirements of the Rule Be Administered?

Proposed trading rules impose a wide variety of requirements on the Parties and on the various international institutions with respect to reporting and monitoring emissions and establishing registries for tracking transactions of AAUs while also making difficult judgments as to ongoing compliance. Any proposed rule must be examined to determine whether it can be administered by the Article 18 compliance entity(ies) and by the buying and selling Parties. Key elements of administerability include simplicity, economic rationality, and tailoring implementation responsibility to the expertise and resources of the administering entity.

Are Transaction Costs Associated With the Rule Acceptable?

Transaction costs take two forms: costs of public administration that are passed on to market participants, and direct costs to market participants that include their own regulatory compliance costs, due diligence expenses, and costs of insurance (if available). The contemplated Kyoto compliance framework already would entail certain costs of public administration at the international level and the domestic level and transaction costs for participants in trading. In evaluating any proposed trading rule, an important question is the extent to which the rule would impose costs or complexity in addition to those already inherent in the Kyoto compliance framework.

Under the contemplated Kyoto compliance framework, costs of public administration at the international level include those involved in maintaining registries, reviewing emission inventories, and operating the administrative machinery necessary to impose sanctions. At the Party level, administrative costs include the expenses of maintaining national registries, monitoring and reporting emissions to international bodies, and administering domestic implementation programs. Costs directly borne by market participants (either legal entities or Parties trading on their own account) include those associated with setting up the commercial infrastructure necessary for effective participation in the market that the trading rules require. For Parties (both originators and intermediate sellers) who trade on their own account, and for legal entities, this is the cost of ensuring that trades will in fact produce either a predictable stream of revenues (in the case of sellers) or of useable AAUs (in the case of buyers). Various proposed trading rules could increase these costs substantially.

The likely level of transaction costs will differ for buyers and sellers, depending on the type of trading rule. For example, various eligibility requirements impose significant transaction costs on originating Parties that must set up administrative infrastructure to meet the criteria. Quantitative constraint rules would require Parties to establish that they are within the terms of the limitation. Nonoriginating Party sellers and buyers, on the other hand, should see much lower transaction costs since the AAUs they buy will be of unquestioned [30 ELR 10849] validity. Acquiring Party Liability, however, imposes high transaction costs on purchasers, in the form of due diligence, continuing monitoring, and—potentially—insurance. Originating Party transaction costs would be the same under Acquiring Party Liability, except to the extent buyers impose specific requirements by contract or extract discounts from high-risk sellers.⁷⁷

Will the Rule Reduce Buyer or Seller Benefits From Trading?

International emissions trading, if fully effective, promises major reductions in compliance costs for Parties with high abatement costs and concomitant economic benefits to parties with low emission reduction costs. Trading rules designed to deter or prevent overselling impose varying degrees of constraint on trades. To the extent that a trading rule (1) delays the earliest date on which AAUs can be traded (as in the Swiss proposal), (2) limits the AAUs available for trading (as in the compliance reserve proposal), (3) excludes certain originating Parties from the international emission trading market, or (4) simply increases transaction costs, the effective price of AAUs to acquiring Parties (or their legal entities) is increased.

For acquiring Parties with high domestic abatement costs, this translates into an increase in compliance costs, and ultimately into an increased risk of their noncompliance. Thus, one key task in evaluating trading proposals is to assess the extent to which they deny Parties the benefits of international emissions trading.

[] Increasing Acquiring Party Compliance Costs. Trading under the contemplated Kyoto compliance framework, i.e, Originating Party Liability with sanctions, imposes minimal transaction costs on acquiring Parties (and their legal entities) and does not limit the total quantity of AAUs available in the international market. Various quantitative constraint rules would limit the amount (and raise the price) of AAUs available to acquiring Parties, but would not increase their transaction costs. (Originating Party transactions costs—which may be passed on to buyers—may be significant however.) Acquiring Party Liability proposals do not necessarily reduce the quantity of AAUs available, but undeniably reduce their quality and vastly increase buyer transaction costs. The "Trigger" option may increase transaction costs because this option entails a switch from Originating Party Liability to Acquiring Party Liability under certain circumstances. Thus, the extent to which AAU prices and transactions costs will increase depends on the specific provisions of particular trading proposals.

In the review of the current trading proposals, this Article specifically assesses the extent to which these proposals reduce buyer benefits from trading.

[] Decreasing Originating Party Emission Reductions and Cash Flow. In a market in which AAUs are freely traded, Parties whose marginal abatement costs are lower than the market clearing price for AAUs will over comply—that is, they will abate emissions more than required by the Protocol in order to profitably sell surplus AAUs. Revenues from these sales can finance all or part of the originating Party's cost of implementing additional emissions reductions or removal measures. Restrictions on trading can have important impacts on this originating Party behavior, especially in the first budget period. If a trading rule excludes an originating Party from the AAU market (as certain proposals would), then that Party's incentives for overcompliance are eliminated and revenue for the would-be seller's emission control projects will be eliminated as well. On the other hand, for originating Parties that remain in the AAU market (those not impacted by eligibility requirements or quantitative restrictions), their higher AAU prices will encourage greater domestic emission reductions, potentially increasing cash flow for project use.

Acquiring Party Liability proposals are likely to reduce AAU prices paid to high-risk Parties and also increase transaction costs as these Parties respond to buyer due diligence demands for greater assurances of compliance.

[] Hampering Trading by Legal Entities. A number of studies that find that international emissions trading will produce lower compliance costs either assume or explicitly stipulate that legal entities are permitted to be full participants in that trading.⁷⁸ Others have argued that limiting trading to Party-to-Party transactions and excluding legal entity trading will sharply curtail the market benefits from trading, apparently on the theory that governments are not likely to be effective profit maximizers.⁷⁹

A review of the extant trading proposals shows that they vary in their impacts on private trading. Originating Party Liability with sanctions does not constrain legal entity trading, at least in the first budget period. Acquiring Party Liability does not directly constrain legal entity trading either. But the possibility that acquiring Party governments will not accept an out-of-compliance Party's AAUs in satisfaction of domestic emission reduction commitments sharply reduces the value of those AAUs in the hands of the buyer. Acquiring Party Liability thus makes legal entity trading a much less attractive compliance option than would Originating Party Liability. Quantitative constraints on originating Parties have the effect of requiring these Parties to reserve from sale specified quantities of AAUs. To carry out these restrictions, AAUs in private hands must be subject to complex rules to ensure that originating Parties do not evade sale limitations by issuing AAUs to legal entities [30 ELR 10850] who in turn resell them for use outside of the originating Party's jurisdiction.⁸⁰

Even though the Protocol provides for a five-year commitment period, some commenters have asserted that risk-averse governments are likely to develop domestic implementation programs that require legal entities to meet annual targets. Annual compliance requirements could have important implications for the market impact of different rules. For example, the Swiss "Units in Surplus to Plan" rule, would effectively delay the commencement of trading until after review of the 2008 emissions inventory, which might not occur until as late as 2010. Under this rule, legal entities facing domestic annual compliance requirements could not use AAUs acquired internationally to meet their requirements for two of the five years of the commitment period. Annual compliance requirements might also make an Acquiring Party. Liability rule problematic. Risk-averse governments that impose annual compliance requirements also might refuse to accept AAUs subject to later devaluation or repatriation for the purposes of meeting those requirements.

[] Specific Considerations Applicable to Acquiring Party Liability. Under Acquiring Party Liability, originating Party's noncompliance invalidates AAUs in the hands of buyers. For that reason, Acquiring Party Liability raises special concerns not presented in other trading rules, including (1) cascading defaults, (2) market fragmentation, and (3) buyer due diligence costs. This section reviews these issues and the questions of whether the higher transaction costs and risks associated with Acquiring Party Liability can be reduced through the use of familiar commercial law instruments.

[] Cascading Defaults. The key provision of an Acquiring Party Liability rule is that if the originating Party fails to comply (a primary default), AAUs held by a purchasing Party would be invalidated for compliance purposes or returned to the originating Party. Purchasers (either Parties or legal entities) that rely for compliance purposes on AAUs that are purchased in international trades and are subsequently invalidated can be pushed into default themselves (a secondary default). To the extent the purchaser Party has sold AAUs it has itself issued, the purchaser of those AAUs can also be pushed into default (a tertiary default).

How realistic this scenario may be is difficult to assess—through a tertiary default seems much less likely than a secondary default, since a Party that purchases AAUs for its own compliance is unlikely to be a major seller of AAUs it issues itself. However, both the specter of cascading defaults and the likelihood that Parties are going to be reluctant to accept AAUs purchased from other Parties for their own domestic compliance purposes could greatly affect the efficacy of international emissions trading, if Acquiring Party Liability is adopted.

[] Market Fragmentation (Price Heterogeneity). The principal rationale for an Acquiring Party Liability rule is that if buyers are at risk, they will force originating Parties to comply with their Article 3 commitments. However, because buyers' assessment of the risk of seller noncompliance will vary from originating Party to originating Party, one should expect different risk-based discounts for AAUs from different Parties, and a market in which there is no unitary market clearing price for AAUs. Mere heterogeneity of prices, however, does not present a serious obstacle to an active emissions trading market. Varying levels of discounts will undoubtedly increase transaction costs, but this price variability is common in, and accommodated by, most financial and commodity markets. For example, in bond markets, traders deal in bonds issued by companies with differing credit ratings. In oil markets, traders deal in crude oil of differing qualities, using a benchmark crude price. Thus, price variation as a result of discounting need not be a major impediment to trading. Of much greater concern, as discussed below, is the transaction cost of establishing the discount.

[] Buyer Due Diligence Costs. A major concern with Acquiring Party Liability proposals is the level of transaction costs associated with buyer due diligence and risk mitigation efforts. Buyers will need to satisfy themselves either that there is a high probability of originating Party compliance or that AAU discounts properly reflect risk of originating Party noncompliance. This is likely to be an expensive and in many cases a frustrating effort, because of lack of access to reliable and current emissions data, and the political risk that a government will not carry out its announced domestic emissions reduction plans. If this due diligence inquiry is pursued by individual purchasers (particularly if they are legal entities), both the costs of the inquiry and the perceived risks are likely to result in significant discounts, which in turn will reduce seller incentives to pursue domestic emission reduction programs beyond those barely necessary for domestic compliance.

However, there is the possibility of using familiar contractual instruments and market practices to reduce both cost and risk of a buyer liability regime in order to render it commercially feasible. Financial and commodity markets have developed a wide range of commercial instruments and market practices to mitigate risks, to allocate them among Parties, and to reduce the cost of assessing risk. These include contracts for future delivery⁸¹; use of standard contracts; sovereign guarantees; rating services; liquidated damages; dispute resolution institutions; commercial insurance; and government-provided political risk insurance.

It is not unreasonable to believe that international emissions trading markets operating under an Acquiring Party Liability rule could develop and institutionalize these instruments. But, putting the instruments in place cannot happen overnight. International emissions trading even with relatively simple trading rules is a complicated enterprise. It may be desirable not to burden this enterprise in its early years with the additional challenge of coping with a full Acquiring Party Liability regime.

[30 ELR 10851]

Does the Proposal Unnecessarily Constrain Trading?

A number of the current proposals introduce much greater constraints on trading, more uncertainty, and higher transaction costs than are necessary to effectively deal with potential overselling. For example, the G-77/China proposal to permit Parties to sell AAUs only after they have been determined to be surplus after the first budget period would effectively preclude overselling but at an unnecessarily steep cost. Less intrusive trading rules which permit trading during the first budget period, could be equally effective in preventing overselling but would not effectively bar trading during the first budget period.⁸²

Conclusions on Workability and Market Impact

Proposed rules must be carefully reviewed for workability and market impact. A trading rule that cannot be administered will not deter overselling. A trading rule whose transactions costs are so high or whose trading constraints are so onerous that it substantially increases all Parties' compliance costs, may decrease rather than increase Parties' likelihood of compliance. Thus, any proposed trading rule should be reviewed to ensure that (a) it can be administered by Parties and international entities, (b) it does not impose unnecessarily high transaction costs, (c) it does not unacceptably reduce benefits of trading to buyer and seller Parties and to legal entities, and (d) it does not impose a greater burden on trading than necessary to prevent or deter overselling.

Evaluation of Proposed Trading Rules

This Article has outlined a recommended framework for evaluating proposed trading rules and introduced some of the most important considerations that apply to the various proposals. This section applies the evaluation framework to assess each of the options in the Chairmen's Negotiating Text.

Originating Party Liability: Option 1

Option 1, which corresponds to the contemplated Kyoto Protocol compliance framework, would provide for a liquid trading market but would not prevent overselling unless substantial legal and political obstacles were overcome, allowing for the implementation of unavoidable and compelling sanctions. Originating Party Liability essentially is the reference case against which one may assess the other options.

Acquiring Party Liability: Options 2-4

Options 2-4 provide for different variations of Acquiring Party Liability ranging from Shared Liability (Option 2) to straight Acquiring Party Liability (Option 3) to the "Trigger" approach (Option 4). This section assesses these different options together.

Effectiveness in Preventing or Deterring Overselling

In general, the Shared Liability (Option 2) and Acquiring Party Liability (Option 3) rules would be more effective than Originating Party Liability (Option 1) in addressing risks of either unintentional or willful overselling.

The virtue of these proposed rules is that they would shift some or all of the risk of overselling onto actors that have stronger incentives to avoid invalidation of AAU sales. Ordinarily, it would make the most sense to impose liability solely on originating Parties since those Parties have the most information about and the greatest ability to control their compliance. However, as noted above, making originating Parties bear the consequences of their overselling alone has potential drawbacks. One of the drawbacks is that an originating Party obtains revenues from overselling and those revenues might exceed the costs of any consequences for overselling that are imposed by international institutions. Accordingly, even if they are subject to sanctions, originating Parties still could have overriding incentives to oversell. By contrast, if acquiring Parties bear some or all of the consequences of purchasing nonsurplus AAUs, those Parties have no possibility for a net gain. They lose their investment in the invalidated AAUs and they might also fall into noncompliance. There is no upside.

According to this logic, Options 2 or 3 would create strong incentives for acquiring Parties and their legal entities to discriminate among originating Parties on the basis of their perceived likelihood of compliance. This heightened scrutiny would give Parties seeking to profit from trading incentives to demonstrate that they were implementing effective domestic compliance programs.

Option 4, the "Trigger" rule, potentially could be as effective in deterring overselling as Options 2 and 3. Under this proposed rule, each Party would trade subject on an Originating Party Liability basis unless and until the occurrence of some condition indicating the Party's higher probability of noncompliance. Subsequently, any trades by the Party would occur on an Acquiring Party Liability basis. The trigger thus would identify high-risk originating Parties and would establish for those buyers the Acquiring Party Liability incentive structure.

However, because the Chairmen's text does not specify the precise circumstances under which a "question" could be raised about a Party's compliance it is difficult to assess the likely effectiveness of this option. One concern with the "Trigger" approach is that it could induce participants in the trading market to rush to make trades early in the commitment period while Originating Party Liability applies and before the triggering event or events occur. If, as is likely, the triggering event would relate to the extent of a Party's cumulative emissions, this approach could be problematic because, as discussed above, submission and review of emissions inventories for any one year of the period could take as long as two or three years. Under such circumstances, Parties could sell off much of their stock of AAUs before the "Trigger" approach had any effect.

Workability and Market Impact

Under any of the Acquiring Party Liability options, the emissions trading market would be a market in which a buyer bears some of the risk of a seller's nonperformance. A variety of markets are structured in this way. Securities markets are an example. Some markets can work quite well as buyer-risk markets; other markets are not sustainable under such an approach. The sustainability of any buyer-risk market [30 ELR 10852] turns on the cost effectiveness of the risk assessment and risk management strategies available to buyers. If these strategies are not cost-effective, a buyer-risk market precludes many "good" transactions, i.e., transactions that do not contribute to the seller's noncompliance. If buyers were discouraged from undertaking "good" trades in an international emissions trading market, they would be implementing more expensive domestic mitigation options unnecessarily.⁸³ What follows is an evaluation of the cost effectiveness of the risk assessment and risk management strategies that would be available to buyers in a buyer-risk emissions trading market.

[] Cost Effectiveness of Risk Assessment Strategies. Risk assessment for buyers is particularly challenging under Options 2 or 3 because, under those proposed rules, if an originating Party fails to meet its Article 3 commitment, all of the AAUs it transferred would be invalidated even if only a small percentage of its total trades were nonsurplus. This approach places unnecessarily stringent restrictions on the liquidity of the trading market. Under either of these rules, the buyer who acquired an AAU in 2008 from a noncompliant Party would suffer the same consequences as the buyer who acquired an AAU from that Party in 2012 even though the latter buyer would have had far better information about the Party's risk of noncompliance. Under either Option 2 or 3, therefore, the earliest buyers would take on a risk that would be highly difficult to assess.

Option 4, the "Trigger" rule, might be more reasonable in this regard because it would apply Acquiring Party Liability only to those buyers who purchased AAUs from a Party deemed to have a high-risk status under the rule. As discussed above, the impact of the "Trigger" rule would be determined, in part, by the condition(s) that would trigger Acquiring Party Liability.

Under any of the Acquiring Party Liability options, buyers would face substantial barriers in assessing the risk of an originating Party's nonperformance. As discussed above, it might take two to three years to obtain information on a Party's annual emissions. Moreover, projecting a Party's future emissions path and AAU sales would require a complex assessment of the effectiveness of its domestic regulatory programs; its general levels of economic activity; and the risk of cascading "defaults."⁸⁴ The most critical information, but the most difficult to obtain, would be the originating Party's planned future trading activity.⁸⁵ And, after all this, a Party's compliance or noncompliance could be determined by unforseeable circumstances in the last year of the commitment period.⁸⁶ For these reasons, risk assessment in an emissions trading market governed by an Acquiring Party Liability regime could be considerably more costly and complicated than risk assessment in other buyer-risk markets.⁸⁷

[] Cost-Effectiveness of Risk Management Strategies. The costs and complexities involved in assessing originating Party risk under an Acquiring Party Liability regime might preclude fewer "good" trades if buyers could rely on cost-effective strategies to manage this risk. Such strategies would include individualized contracts with sellers, buyer or seller insurance, and political pressure or aid. However, these risk management strategies, like the risk assessment strategies, would be costly and difficult to implement in an international emissions trading market.

[] Contractual Mechanisms. As discussed above, buyers and sellers could structure a variety of contracts for distributing and managing the risk of the originating Party's liability. However, negotiating individualized contracts with sellers would require substantial resources. Enforcing such contracts also would be costly and subject to significant uncertainty, especially where the seller was a sovereign.

[] Buyer or Seller Insurance Policies. Buyers also could purchase insurance to cover transactions or condition their acquisition of AAUs on the seller's purchase of insurance. Yet, this strategy might also be problematic. In response to a 1998 survey, some major insurance providers expressed substantial reservations about insuring emissions trades.⁸⁸

[] Political Pressure/Aid. An additional means of insuring against invalidation risks would be for acquiring Party governments to impose political pressure on originating Party governments to comply or, alternatively, to provide them with compliance assistance. However, all acquiring Party governments will evaluate the utilization of political capital and foreign aid for such purposes against a variety of competing policy priorities.

Viability of an Emissions Trading Market Governed by an Acquiring Party Liability Rule

Given these difficulties of assessing and managing the risks of originating Party noncompliance, the viability of an emissions trading market governed by an Acquiring Party Liability rule would depend in large part on the quantity of resources available to buyers and their appetite for risk.

What then might a market governed by an Acquiring Party Liability rule look like? The costs involved in evaluating and contracting around originating Party risk might make only large acquisitions from large Parties a cost-effective use of resources.⁸⁹ These costs might have the effect of [30 ELR 10853] discouraging many smaller or less market-savvy legal entities from participating as buyers at all.

Indeed, since acquiring Party governments would ultimately bear the risk of noncompliance resulting from invalidation of AAUs, they likely would want to regulate participation by legal entities in such a market closely. Some risk-averse acquiring Party governments might prohibit participation by legal entities in the international market altogether.⁹⁰

Conclusions

While the "lag-time" factor makes it unlikely that the "Trigger" rule (Option 4) could be effective in preventing overselling, the Shared Liability (Option 2) and Acquiring Party Liability (Option 3) rules could be highly effective. The effectiveness of these options in preventing overselling, however, could come at a very high cost to the emissions trading market. Given the substantial market uncertainties introduced by these approaches, negotiators also should consider alternative rules that could achieve similar effectiveness in minimizing overselling risks but that would have a smaller market impact. An Acquiring Party Liability rule could be a useful supplement to such an alternative approach.

Originating Party Liability With Quantitative Constraint: Options 5-6

Options 5 (Compliance Reserve) and 6 (Units in Surplus) reflect what we have called the "Originating Party Liability with Quantitative Constraint" approach. This approach would maintain liability in originating Parties but impose a limit on the proportion of AAUs they could sell. Options 5 and 6 incorporate different formulas aimed at making Parties hold in reserve the AAUs they would need to cover their 2008-2012 emissions.

Option 5: Compliance Reserve

[] Effectiveness in Preventing or Deterring Overselling. This rule provides a particular, but as yet unspecified, percentage of every transfer of AAUs would have to be placed in a "compliance reserve." AAUs in the compliance reserve could not be used or traded. At the end of the commitment period, AAUs in the compliance reserve would be returned to their originating Parties if those Parties were in compliance with their Article 3 commitments. Those Parties then could transfer the AAUs during a post-2012 "true-up" period or bank them for future commitment periods. On the other hand, an originating Party that exceeded its Article 3 commitment would see a corresponding amount of its AAUs in the compliance reserve invalidated, in which case they could not be traded or banked.

As stated above, the Chairman's Negotiating Text seems to contemplate a single reserve percentage that would apply to each Party, but the text does not specify the percentage. Presumably, the reserve percentage should be calibrated to ensure that each originating Party sets aside a proportion of its AAUs that is sufficient to cover its emissions during the commitment period.

The problem with this option is that there is no optimal percentage that fits the circumstances of each country.⁹¹ Moreover, there is considerable variance in those circumstances. As explained earlier, the Protocol has allocated to some countries assigned amounts much higher than their business-as-usual emission levels. The Protocol has allocated to other countries assigned amounts much lower than their current emissions. Accordingly, a particular reserve percentage could have very different results for different countries. If the specified reserve percentage is too low for certain countries, it will not prevent those countries from overselling.

Workability and Market Impact

Conversely, a reserve percentage that is too high for many countries may be effective in preventing overselling by those countries but may also prevent many "good" trades. The reserve percentage thus can be suboptimal in either direction.

In addition, it does not seem necessary to prohibit the reserved AAUs from being sold at all. Allowing buyers to acquire reserved AAUs subject to Acquiring Party Liability would provide for greater liquidity without significantly increasing overselling risks.

Conclusions

The primary difficulty with the Compliance Reserve proposal is its apparent reliance on a uniform percentage reserve requirement for each Party. The proposal would come closer ot satisfying the criteria outlined earlier if it incorporated a formula that assigned a reserve percentage to each Party on the basis of its individual circumstances. For example, one could determine each Party's reserve requirement on the basis of an estimate of its likely 2008-2012 emissions. Another approach could allow a Party to petition the compliance institution for a particular reserve percentage.

Option 6: Units in Surplus to Plan

[] Effectiveness in Preventing or Deterring Overselling. The "Units in Surplus to Plan" proposed by the government of Switzerland would be substantially more effective in preventing overselling than the contemplated Kyoto Protocol compliance framework (Originating Party Liability). Because of the "lag-time" issue identified earlier, it would be possible for a Party trading subject to an Originating Party Liability rule to sell most or all of its five-year allotment of AAUs before it became clear that its emissions were accumulating at a dangerous rate. The "Units in Surplus to Plan" approach would avoid this risk by linking trading to the review of annual emissions inventories.

[30 ELR 10854]

As described above, the proposed rule would require a Party wishing to trade AAUs to first allocate its allotment of AAUs roughly evenly among each of the five years of the commitment period. In any year of the period, a Party could sell only those AAUs allocated to that year and any unsold AAUs allocated to previous years that were surplus to its cumulative emissions. The rule's annual post-verification trading approach would limit a Party's annual sales to those AAUs that were actually surplus to its cumulative emissions.

The Swiss proposal would not eliminate the risk of overselling entirely. The rule makes possible a "front-loading" scenario in which it would be possible to comply with the rule yet still oversell by a certain amount. Under this scenario, a Party would allocate the maximum annual allocation (1/5 of total Assigned Amount + 20%) to each of the first three or four years of the commitment period and then maintain sufficiently low emissions to issue a sizable proportion of its AAUs early in the commitment period.⁹² If its annual level of emissions stayed the same or increased in the fourth or fifth years of the commitment period, the annual surplus rule would prevent the Party from issuing AAUs in those years. However, as a result of AAU transactions in the early years of the commitment period, the Party might not hold sufficient AAUs to cover its cumulative emissions at the end of the period. The Swiss proposal necessarily must rely on penalties and other elements of the Article 18 compliance regime to deter this front-loading overselling scenario.⁹³

In the balance, however, the "Units in Surplus to Plan" rule would substantially reduce the risks of overselling and the amount of overselling that could occur. From this perspective, it would be a significant improvement on the "Originating Party Liability" framework.

Workability and Market Impact

While the "Units in Surplus Rule" would be much more effective in preventing overselling than the Protocol's contemplated compliance framework, it could prevent a substantial number of "good" trades in the first commitment period.

A shortcoming of the Swiss regime is that it would delay the commencement of trading in the first commitment period. Under the Swiss proposal, no Party could begin issuing AAUs until the compliance institution had determined whether and by how much its 2008 allocation of AAUs exceeded its 2008 emissions. Yet, as discussed above, these determinations might not be completed until 2010 or even 2011.

Accordingly, under the structure of the Swiss proposal, Parties might not be able to commence emissions trading until midway through the first commitment period. This delay would reduce the total number of AAUs available in the emissions trading market during the first commitment period to a fraction of what might be the quantity of AAUs that actually turned out to be surplus to Parties' compliance needs.

The effect of this delay would be confined to the first commitment period. Surplus AAUs not sold could be carried over to the second commitment period. Assuming there will be multiple future commitment periods, the adverse impact of the initial delay therefore would be minor in the long run but potentially disruptive in the short run. In the end, decisionmakers evaluating the Swiss proposal will have to balance the long-term benefits of minimizing first commitment period overselling risks against the long-term costs of minimizing early opportunities for utilizing trading for compliance.

Another important impact of the annual surplus trading rule would be the transformation of the emissions trading market into a series of one-year markets in which the amount of AAUs available would depend on each Party's emissions performance for that year. This approach would introduce uncertainties into the market as the quantity of certified surplus AAUs fluctuated annually. It would be difficult to predict how many AAUs would be available for sale in any one year.

These impacts of delay and uncertainty would tend to hamper participation by legal entities as buyers. If governments impose an annual compliance requirement on their legal entities, the annual surplus trading rule would mean that legal entities could not rely on acquisitions of AAUs to meet their obligations in at least the first two years of the commitment period. Legal entities then would confront uncertainties with respect to the amount of AAUs available for purchase in each of the remaining years of the period.

Providing for delay and uncertainty would not pose too many problems for buyers if they could substitute domestic mitigation activities for AAUs quickly and at low cost. However, at the current time, domestic mitigation activities that can generate substantial amounts of emission reductions, such as fuel switching or technology changes, are capital-intensive and can take several years to implement. As a result, the costs of ensuring against the delay and uncertainty caused by the annual surplus trading rule could be very high.

Under the rule, governments and legal entities for whom domestic mitigation costs were high, and who therefore could benefit from acquiring AAUs, nevertheless would have to invest heavily in domestic activities in order to meet their obligations in the first two years of the commitment period and to ensure against the possibility that only a small quantity of AAUs would become available later in the period. These costs would represent opportunity costs if it turned out that issuing Parties were able to generate many surplus AAUs.⁹⁴

The impacts of delay and uncertainty could be somewhat mitigated by the ability of Parties and legal entities to engage in forward and options contracts. As discussed above, such commercial transactions however, are not a perfect replacement for registry-based trades. Registry-based trades [30 ELR 10855] provide for immediate delivery; commercial transactions entail a promise of future delivery of AAUs. The risk of nondelivery introduces additional transaction costs. For example, buyers engaging in commercial transactions in a market governed by the Swiss rule would incur search costs assessing the likelihood that prospective issuers would have certified surplus AAUs at the end of the year. They also would incur negotiating costs in structuring individualized transactions with issuers. Some buyers would incur the further costs of monitoring issuer performance and ensuring against nondelivery. Finally, some buyers would incur costs enforcing their agreements against issuers who reneged on their promise of delivery. Even if buyers were to transfer many of these transaction costs to issuers in the form of lower prices, the final result still would be significantly fewer transactions.

Another possible difficulty with a rule such as that proposed by the Swiss is that a legal entity that acquired AAUs in its country's domestic market and found that it did not need them would not have the option to resell those AAUs in the international market unless and until it was determined that its country as a whole had generated a surplus in a particular year. One option for a legal entity in such a situation would be to exchange its surplus AAUs for CERs and then resell the CERs, assuming that the rules for the mechanisms provide that AAUs, ERUs, and CERs are fungible.

The Swiss annual surplus trading rule would all but eliminate risks of overselling due to administrative failure or willful noncompliance. The annual surplus trading rule, however, could impose significant constraints on the emissions trading market in the forms of delay, illiquidity, and uncertainty. Because of these impacts on the emissions trading market, there is some danger that the annual surplus trading rule could result in a higher net risk of noncompliance and penalties. A rule that approached the effectiveness of the annual surplus trading rule in minimizing overselling risks while imposing a less substantial burden on emissions trading would be preferable.

Conclusion

International GHG emissions trading will be a key element of the Kyoto Protocol or any future global climate change regime. Emissions trading can reduce the cost of compliance with emission limitations.

Emissions trading, however, also introduces risk of noncompliance in the form of overselling of AAUs. A Party could oversell as a result of a good-faith failure to manage its international trading program or it could oversell for financial gain.

Ordinarily, the best way to address this or any other risk of noncompliance is to design effective systems of implementation review and establish unavoidable sanctions that exceed the benefits that can be derived from noncompliance. Establishing such an approach under the Protocol would impose the least restrictions on the operation of the emissions trading market. Moreover, by all accounts, this approach has been effective in the case of the U.S. SO₂ program, the precedent for the Protocol's emissions trading program.

Unfortunately, a number of obstacles stand in the way of implementing this approach in the context of the Protocol. While information on a Party's sales of AAUs should be available in real-time, information on a Party's emissions could be subject to a two- to three-year delay. This "lag-time" problem is likely to render the Protocol's system of implementation review ineffective in preventing overselling. In addition, the establishment of sizeable and inescapable sanctions is fraught with legal, substantive, and institutional difficulties.

Because of these difficulties, it is improbable that the currently contemplated compliance framework can prevent overselling. If negotiators, therefore, conclude that there is a significant risk that overselling will occur—a risk which is not formally assessed in this Article—they will need to consider an additional safeguard. This Article has identified three criteria for assessing proposed trading rules. First, the rule should be effective against not only the well-meaning but also the willful overseller. Second, it must be feasible for the nascent Kyoto Protocol compliance institution to implement the rule.

Finally, the rule should not preclude an ordinate number of "good" trades. A rule that creates too many obstacles to a workable and liquid trading market will hamper the ability of emissions trading to reduce compliance costs. A rule that leads to higher compliance costs could cause more noncompliance in the first commitment period than it prevents.

Higher compliance costs also could have detrimental effects on the evolution of the climate regime in the long term. It is important to keep in mind that the Kyoto Protocol's first commitment period is contemplated as a first step in a multidecade global effort to reduce concentrations of GHGs—the stated objective of the UNFCCC. It makes little sense to adopt a policy that aims to achieve perfect compliance with first commitment period obligations if the policy reduces incentives for countries to participate in the effort to achieve long-term climate policy objectives.

The proposals appearing in the April 2000 version of the official Chairmen's Negotiating Text address some, but not all, of these criteria. However, the proposed rules either would be ineffective in addressing risks of rogue overselling (Originating Party Liability, Trigger, and Compliance Reserve) or would impose prohibitive burdens on the trading market (Acquiring Party Liability, Shared Liability, Units in Surplus to Plan, and Surplus Units).

Liability rules are likely to have a significant impact on an emissions trading market. Accordingly, as we approach COP-6, negotiators are faced with a difficult decision, which could have a substantial impact on the first commitment period and the long-term achievement of climate policy objectives. For these reasons, it is important that negotiators are fully informed in the near term of both: the environmental and economic consequences of their decisions in the first commitment period and how their decisions will affect the long-term climate policy objectives.

1. Kyoto Protocol to the United Nations Framework Convention on Climate Change, U.N. Doc. FCCC/CP/1997/7/Add.2, reprinted in 37 I.L.M. 22 (1998) [hereinafter Kyoto Protocol].

2. United Nations Framework Convention on Climate Change, opened for signature June 4, 1992, S. TREATY DOC. NO. 102-38 (1992), reprinted in 31 I.L.M. 849 (1992) (entered into force Mar. 21, 1994) [hereinafter UNFCCC].

3. To enter into force, the Protocol must be ratified by at least 55% of the Parties to the UNFCCC, including Annex 1 Parties representing at least 55% of the 1990 carbon dioxide emissions for these Parties. See Kyoto Protocol, supra note 1, art. 25.1.

4. The countries listed in Annex B are: Australia, Austria, Belgium, Bulgaria, Canada, Croatia, Czech Republic, Denmark, Estonia, European Community, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Latvia, Liechtenstein, Lithuania, Luxembourg, Monaco, Netherlands, New Zealand, Norway, Poland, Portugal, Romania, Russian Federation, Slovakia, Slovenia, Spain, Sweden, Switzerland, Ukraine, United Kingdom, and the United States of America.

5. The term Assigned Amount Unit (AAU) is a widely used shorthand for the units transferrable through the Article 17 mechanism. Parts of Assigned Amount (PAA) is another term used to refer to the same units. These terms, however, do not appear in the Protocol. In its proposal regarding the establishment of a negotiating text on the various Kyoto mechanisms, the Group of 77/China has recommended that the term AAU "be considered as bracketed where it occurs in [the negotiating text]." Subsidiary Body for Scientific and Technical Advice and Subsidiary Body for Implementation, Note by the Chairmen: Mechanisms Pursuant to Articles 6, 12, and 17—Text for Further Negotiation on Principles, Modalities, Rules and Guidelines, FCCC/SB/2000/3 (Apr. 12, 2000) (available at http://www.unfccc.de/resource/docs/2000/sb/03.htm) [hereinafter Chairmen's Negotiating Text].

6. The list of countries in Annex B of the Protocol is identical to those listed in Annex I of the UNFCCC with a few minor exceptions. Belarus is an Annex I country but does not appear on the Annex B list. Turkey, which appears on the Annex I list, has requested that it be removed from that list in light of its state of economic development.This request is still pending. Turkey has ratified neither the UNFCCC nor the Protocol.

7. See Kyoto Protocol, supra note 1, art. 6.1(b).

8. Id. art. 3.10.

9. Id. art. 3.12.

10. Id. art. 12.5(b).

11. Id. art. 12.2.

12. Id. art. 12.5

13. See Chairmen's Negotiating Text, supra note 5, at 65, P194.

14. See id. at 119, P340(g).

15. Clare Breidenich, et al., The Kyoto Protocol to the United Nations Framework Convention on Climate Change, 92 Am. J. Int'l L. 315, 321 (1998).

16. See, e.g., J.P. Weyant & J. N. Hill, Introduction and Overview, the Costs of the Kyoto Protocol: A Multi-Model Evaluation, in ENERGY J: SPECIAL ISSUE—THE COSTS OF THE KYOTO PROTOCOL: A MULTIMODEL EVALUATION ii (1999) (providing an overview of articles in the special issue which describe results from 13 models, all of which show that the availability of emissions trading substantially reduces the costs of compliance with the Protocol's emission targets); JAE EDMONDS ET AL., INTERNATIONAL EMISSIONS TRADING & GLOBAL CLIMATE CHANGE (Pew Center on Global Climate Change 1999).

17. Parties could overcomply for two reasons: (1) they have low domestic marginal abatement costs relative to their Article 3 commitment and/or (2) the Protocol has provided them with an assigned amount above their projected business-as-usual emissions and therefore they will have surplus AAUs without undertaking any new abatement activities. Some commenters pejoratively refer to the surplus AAUs in the second scenario as "hot air."

18. See Kyoto Protocol, supra note 1, art. 5.1.

19. See id. art. 5.2. The Protocol provides that the COP shall serve as the Conference of the Parties meeting as Parties to this Protocol (COP/moP). Id. art. 13.1. It further provides, however, that decisions by the COP/moP with regard to the Protocol shall be made only by those governments that are parties to both the UNFCCC and the Protocol. Id. art. 13.2.

20. Id. art. 7.1.

21. Id. art. 7.4.

22. See, e.g., Chairmen's Negotiating Text, supra note 5, at 125, P343(d).

23. Id.

24. Id.

25. See Kyoto Protocol, supra note 1, art. 8.3.

26. See Procedures and Mechanisms Relating to Compliance Under the Kyoto Protocol, Note by the Chairmen of the Joint Working Group on Compliance, FCCC/SB/2000/1 (Apr. 4, 2000) (available at http://www.unfccc.de/resource/docs/2000/sb/01.htm).

27. Id.

28. INTERNATIONAL INSTITUTE FOR SUSTAINABLE DEVELOPMENT, SUMMARY OF THE WORKSHOP ON COMPLIANCE UNDER THE KYOTO PROTOCOL: 1-3 MARCH 1999, reprinted in 12 EARTH NEGOTIATIONS BULL, 4 (2000) (available at http://www.iisd.ca/climate/cop6/tech_ws/compliance/).

29. Personal communication with Christian Albrecht, State Secretariat for Economic Affairs, Government of Switzerland.

30. See Kyoto Protocol, supra note 1, art. 18.

31. Id. art. 27.

32. See, e.g., Center for International Environmental Law, Comments on Selected Portions of the JWGC Co-Chairs' "Elements" Paper, (Jan. 2000) (available at http://www.ciel.org/pubccp.html).

33. See, e.g., Compliance-Related Issues, Submission of the United States to the U.N. Framework Convention on Climate Change Secretariat, Jan. 31, 2000, released by the Bureaus of Oceans and International Environmental and Scientific Affairs, U.S. Department of State, Feb. 4, 2000 (available at http://www.state.gov/www/global/global_issues/climate/000131_unfccc1_subm.html).

34. See 2278th Council—Environment Meeting, Luxembourg, Community Strategy on Climate Change—Council Conclusions (June 22, 2000) (press release)(available at http://www.weathervane.rff.org/refdoes/EU-ENVIRONMENT_Ministers_062200.htm).

35. To remedy this problem, some commenters have suggested that these penalties go toward environmental restitution in the form of emissions reductions or removal projects. See CENTER FOR INTERNATIONAL ENVIRONMENTAL LAW, THE COMPLIANCE FUND: A NEW TOOL FOR ACHIEVING COMPLIANCE UNDER THE KYOTO PROTOCOL (June 1999) (available at http://www.ciel.org/pubccp.html).

36. See ENGAGING COUNTRIES: STRENGTHENING COMPLIANCE WITH INTERNATIONAL ENVIRONMENTAL ACCORDS (Edith Brown Weiss & Harold K. Jacobson eds., 1999) [hereinafter ENGAGING COUNTRIES]; THE IMPLEMENTATION AND EFFECTIVENESS OF INTERNATIONAL ENVIRONMENTAL COMMITMENTS: THEORY AND PRACTICE (David G. Victor et al. eds., 1998) [hereinafter IMPLEMENTATION AND EFFECTIVENESS OF INTERNATIONAL ENVIRONMENTAL COMMITMENTS].

37. Even a true-up period at the end of the commitment period might not be sufficient to prevent a Party from overselling due to administrative failure. This would be the case if (1) the Party lacked adequate capacity to implement the needed acquisitions of AAUs, ERUs, or CERs, and/or (2) the Party's deficit was so great by the time of the true-up period that it could not acquire an adequate amount of AAUs, ERUs, or CERs, due to a lack of resources or a lack of supply in the market.

38. For example, two studies of compliance with international environmental treaties report that most of the EITs have failed to meet their commitments to eliminate use of ozone-depleting substances in accordance with the 1987 Montreal Protocol on Substances That Deplete the Ozone Layer. See ENGAGING COUNTRIES, supra note 36; Implementation and Effectiveness of International Commitments, supra note 36, at 682 (concluding that the EITs' implementation problems largely have reflected their "limited ability to control the firms within their borders.").

39. The 1998 experience with Russia and the International Monetary Fund (IMF) is instructive in this regard. Three days after the government pledged that it would repay a series of loans from the IMF and that it would not devalue the ruble, the government reneged on these pledges in order to address an economic crisis even though it thereby jeopardized the country's eligibility for future needed loans. See Russia Devalued, ECONOMIST, Aug. 22, 1998, at 15.

40. See George W. Downs et al., Is the Good News About Compliance Good News About Cooperation?, 50 INT'L ORG. 379 (1996).

41. Past practice with respect to self-monitoring and reporting by governments suggests additional reasons for concern. In their study of compliance with international environmental accords, Professors Weiss and Jacobson found that governments regularly fail to fulfill monitoring and reporting obligations. ENGAGING COUNTRIES, supra note 36. A 1992 study by the U.S. Government Accounting Office made similar findings. U.S. GAO, INTERNATIONAL AGREEMENTS ARE NOT WELL MONITORED (1992). These studies suggest that merely imposing a legal obligation on governments to undertake self-monitoring and reporting may not be sufficient to ensure the consistent implementation of those commitments.

42. See 40 C.F.R. § 75.5(e).

43. 42 U.S.C. § 7413(c)(2)(C).

44. It might be feasible to require that each Annex B Party operate CEMS on its large stationary sources of GHG emissions.

45. See Kyoto Protocol, supra note 1, art. 18.

46. Id.

47. Article 20.2 states that amendments shall be adopted at an "ordinary session of the conference of the Parties serving as the meeting of the Parties" to the Kyoto Protocol. Such a session does not occur until the Protocol has entered into force (Article 13.6).

48. See id. art. 20.3.

49. Id. art. 27.

50. The Chairmen's Negotiating Text incorporates this rule as a possible eligibility requirement. See Chairmen's Negotiating Text, supra note 5, at 124, P343(b).

51. According to one study that used an economic model to assess proposed liability rules, a repayment sanction would have to be at least 2.3 times the expected market price of an AAU to exceed the financial benefits of overselling during the commitment period. ERIK HAITES & FANNY MISSFELDT, LIABILITY RULES FOR INTERNATIONAL GREENHOUSE GAS TRADING (EPRI Working Paper, 2000) (on file with authors).

52. ENGAGING COUNTRIES, supra note 36; IMPLEMENTATION AND EFFECTIVENESS OF INTERNATIONAL ENVIRONMENTAL COMMITMENTS, supra note 36.

53. ABRAM & ANTONIA CHAYES, THE NEW SOVEREIGNTY: COMPLIANCE WITH INTERNATIONAL REGULATORY AGREEMENTS 32 (1995).

54. See THOMAS FRANCK, THE POWER OF LEGITIMACY AMONG NATIONS (1990) (asserting that a nation's compliance with an international rule is a function, in great part, of its perception of the extent that the rule is rooted in a set of processes and norms generally deemed to be legitimate and fair).

55. Presumably, the Parties could establish a rule excusing from sanctions those Parties whose noncompliance resulted from good-faith administrative failure. However, such a rule would be very complicated for the compliance institution to administer because it would be exceedingly difficult to determine an overselling Party's "intent." Indeed, this difficulty would make such a rule vulnerable to exploitation.

56. See 42 U.S.C. § 113(c)(1) (providing for criminal liability for any person who knowingly violates "any requirement or prohibition of subchapter IV-A of this subchapter [relating to acid deposition control]").

57. See Scott Barrett, Political Economy of the Kyoto Protocol, 14 OXFORD REV. ECON. POL'Y 20, 35-37 (1998) (asserting that "compliance enforcement and free-rider deterrence are related problems and should be analysed jointly").

58. Another insight that comes from taking the long view is the realization that a rule adopted to address circumstances in the first commitment period might be inappropriate for subsequent commitment periods. While it might be optimal to periodically revisit and perhaps revise a trading rule for this reason, two factors militate against the feasibility of this approach. First, international lawmaking is a cumbersome process; once a trading rule is established, it will be difficult to have nearly 180 sovereign nations agree on later changes to it. Second, governments and legal entities are likely to make substantial investments in reliance on a certain rule. These investments would be stranded costs if the rule changed. For these reasons, it is important to anticipate whether a proposed rule will work for the long term. In addition, it is vital that negotiators consider how governments might change their behavior in response to the rule. For example, negotiators should assess whether a rule would induce governments to negotiate different assigned amounts for themselves than they would otherwise.

59. See, e.g., IMPLEMENTATION AND EFFECTIVENESS OF INTERNATIONAL ENVIRONMENTAL COMMITMENTS, supra note 36, at 693 (asserting that "the ability of a regime to bend, but not break, gives it strength and resiliency over time and allows for deeper commitments).

60. See Chairmen's Negotiating Text, supra note 5.

61. See id. at 127-29, PP357-362.

62. EMISSIONS MARKETING ASS'N & ENVIRONMENTAL DEFENSE FUND, EMISSIONS TRADING EDUCATION: EMISSIONS TRADING HANDBOOK (1999) (available at http://www.etei.org).

63. See Chairmen's Negotiating Text, supra note 5, at 127, P357.

64. Under this approach, Parties that authorize their legal entities to acquire AAUs presumably would promulgate domestic rules that would give these entities incentives to assess the AAUs they sought to acquire.

65. See Chairmen's Negotiating Text, supra note 5, at 127, P357.

66. Id.

67. Id.

68. Id.

69. Id.

70. Id.

71. Id.

72. Id. at 128, P357.

73. Id. The proposed rule further provides that:

The amount of excess AAU certificates issued for previous years of the commitment period and cumulative ERUs transferred under Article 6 shall be subtracted to obtain the annual excess AAUs. Holding of ERUs and CERs shall not be included in the calculation.

Id.

74. In the context of this study, the phrase, "making the environment whole," attempts to capture the notion of remedying a Party's noncompliance with its Article 3 commitment. Understandably, the Article 3 obligations for the first commitment period of the Kyoto Protocol do not stabilize concentrations of GHG. Thus, a Party's compliance with the Protocol's first period commitments will not make the environment whole in that sense.

75. As mentioned above, one avenue through which there might be independent review of individual JI projects is suggested by Article 6.4 which provides:

If a question of implementation by a Party included in Annex I of the requirements referred to in this Article is identified in accordance with the relevant provisions of Article 8, transfers and acquisitions of emission reduction units may continue to be made after the question has been identified, provided that any such units may not be used by a Party to meet its commitments under Article 3 until any issue of compliance is resolved.

If the governments rely on Article 6.4 to empower expert review teams to certify JI projects and/or validate emission reductions obtained by those projects on an annual basis, then it might not be necessary to further regulate such projects with rules aimed at preventing overselling under Article 17. This depends on the structure of the Article 17 rule.

76. One concern expressed in connection with making ERUs freely tradeable by Parties that are barred or constrained under the trading rules from selling AAUs is that the JI alternative will undercut the incentives that trading rules may provide for monitoring and reporting and, ultimately, for compliance. This Article arrives at a different conclusion. So long as JI projects are subject to an independent review and do not contribute to a host country's noncompliance, the benefits to all Parties from access to low cost ERUs will exceed any loss of hypothetical incentives that might arise out of trading rules to monitor, report, and meet the Article 3 commitments.

77. Dudek and Wiener provide a useful taxonomy of costs generic to any kind of transaction. "Search costs" are costs involved in finding interested partners to a transaction. Once participants have identified one another, they must incur "negotiation costs" in coming to terms for the transaction. "Approval costs" arise if the transaction requires the approval of domestic or international institutions. Participants can incur "monitoring costs" if they have a continuing interest in the value of the good or service that is the subject of the transaction. If a participant detects inconsistencies between what has been promised and what actually has occurred, it will incur "enforcement costs" if it insists on compliance. Finally, the risk of transaction failure may induce participants to incur "insurance costs." Insurance can take a number of forms, from actual commercial insurance to investment in a diversified portfolio of the relevant good or service. See DANIEL J. DUDEK & JONATHAN BAERT WIENER, ORGANIZATION FOR ECONOMIC COOPERATION AND DEVELOPMENT, JOINT IMPLEMENTATION, TRANSACTION COSTS, AND CLIMATE CHANGE 15 (1996).

78. See Weyant & Hill, supra note 16; Edmonds et al., supra note 16.

79. This view is seemingly contradicted by the further concern that governments might become too good at trading and, in the process, exercise market power.

80. For example, the Swiss proposal prohibits sale of AAUs allocated to a budget period year until they have been determined to be surplus to emissions. Legal entities are permitted to engage in unrestricted domestic trading, but are sharply restricted in their ability to trade internationally—any domestic legal entity that wishes to trade internationally may trade only AAUs that the UNFCCC Secretariat certifies as surplus and, in addition, must be subject to a domestic cap and trade program.

81. These would include a contract with interim payments: seller promises to transfer units on a later date certain; buyer promises to make interim payments upon the originating Party's meeting specified conditions, e.g., compliance with Article 5 and 7 requirements, achievement of certain emission levels, etc.

82. See, e.g., the "Units in Surplus to Plan" proposal evaluated hereinabove.

83. TIM HARGRAVE ET AL., CENTER FOR CLEAN AIR POLICY, LEIDEN INTERNATIONAL EMISSIONS TRADING PAPERS, DEFINING KYOTO PROTOCOL NON-COMPLIANCE PROCEDURES AND MECHANISMS 28 (Oct. 1999) (available at http://www.ccap.org).

84. See discussion hereinabove.

85. HARGRAVE ET AL., supra note 83, at 27.

86. Id.

87. Another issue is the risk that information provided by originating Party governments and rating services could be fraudulent. It is also important to note that information provided to buyers in the Protocol's emissions trading market would not come with the same legal safeguards as information provided in other well-established buyer-risk markets. The securities market in the United States, for example, is buttressed by an extensive legal infrastructure designed to protect buyers from false or incomplete information. Statutes and regulations require a range of frequent reports and other disclosures by issuers of securities. Issuers are subject to severe penalties for material misstatements and omissions in these disclosures. It appears unlikely that so extensive a set of protections for buyers will be available in the Protocol's emissions trading market, at least in the first commitment period.

88. See Erik Haites, International Emissions Trading and Compliance With Greenhouse Gas Commitments 12-13 (International Academy of the Environment, Climate Change in the Global Economy Programme, unpublished Working Paper No. 77, 1998).

89. HARGRAVE ET AL., supra note 83, at 30.

90. Another market impact of Acquiring Party Liability approach that bears analysis is price heterogeneity. While the rules providing for issuing Party Liability would have lead to AAUs having a single price, the Acquiring Party Liability approach, by design, would result in different prices for AAUs depending on the perceived risk of the issuing Party's noncompliance. Some observers fear that an unintended consequence of such price heterogeneity would be to make the emissions trading market vulnerable to the exertion of market power. See id. at 29. Another view is that such heterogeneity makes it much more difficult for a cartel to enforce pricing agreements (since cheating by cartel members is much harder to detect).

91. Haites, supra note 88.

92. For example, the Party could establish the following allocation: (Assigned Amount/5) + 20% to year 2008; (Assigned Amount/5) + 20% to year 2009; (Assigned Amount/5) to year 2010; (Assigned Amount/5) - 20% to year 2011; and (Assigned Amount/5) - 20% to year 2012.

93. The Swiss proposal limits its focus on preventing overselling and therefore does not address or propose penalties in the event of noncompliance. In other fora, the Swiss government has indicated its preference for strong financial sanctions for Parties that fail to meet their Article 3 commitments.

94. Another option for prospective buyers unable to acquire AAUs during the first two years of the commitment period would be to acquire CERs, which could become available even before 2008. The viability of this alternative would depend on the supply of CERs and their market price.

30 ELR 10837 | Environmental Law Reporter | copyright © 2000 | All rights reserved